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Victoria by the Bay housing development in Hercules continues to build new homes within the development along the bay. Public Policy Insitute of California claim the shortfall of housing is exaggerated.
Event on 3/9/04 in Hercules. Eric Luse / The Chronicle Ran on: 06-15-2004
Liem Bui, above, checks a circuit board at Flextronics Semiconductor in San Jose. The number of jobs in Santa Clara County is still below the peak of March 2001. In Alameda and Contra Costa counties, construction, below, was May's biggest job-generator. Ran on: 05-29-2005
San Francisco's central business district just experienced its best quarter in commercial leasing since the dot-com era, but it would take three years at that rate to soak up the vacant space. Ran on: 05-29-2005
San Francisco's central business district just experienced its best quarter in commercial leasing since the dot-com era, but it would take three years at that rate to soak up the vacant space. MANDATORY CREDIT FOR PHOTOG AND SF CHRONICLE/ -MAGS OUT

Photo: Eric Luse

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Victoria by the Bay housing development in...

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Single family house construction in Manteca.
CHRONICLE PHOTO BY MICHAEL MALONEY CAT

Photo: MICHAEL MALONEY

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Single family house construction in...

What if housing bubble bursts? / Experts can't agree, but they know booming home market has helped economy

Amid signs that rising interest rates could be cooling the housing market, economists are asking how a home price correction would affect the broader economy.

Making such forecasts involves devilish guesses because economists are still divided over how much housing prices may be overheated, whether price excesses are national or regional and how quickly and deeply price corrections could occur.

"We just don't know," said David Berson, chief economist for Fannie Mae, the quasi-public mortgage giant in Washington.

Many experts have used the term "housing bubble" to describe the overheated housing market. It's a bit of a misnomer because even when home prices fall, they do not pop overnight like stocks. Instead, they deflate gradually.

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Federal Reserve Chairman Alan Greenspan raised the volume of the debate when he told Congress last month that "while it is difficult to ascertain" whether average home prices nationwide are overvalued, "there do appear to be, at minimum, signs of froth in some local markets."

One thing seems certain: The booming housing market has been a huge source of stimulus to the economy in general and the job market in particular in recent years.

In one recent study, Wells Fargo economists Michael Swanson and Scott Anderson estimated that more than half of all the payroll jobs created since the end of the last recession were either in construction or in allied fields such as real estate, financing and home improvement.

"Double-digit increases in home prices are not sustainable," said Orawin Velz, chief forecaster for the Mortgage Bankers Association in Washington. She predicts that home prices will appreciate an average of 4 percent nationwide in 2006 -- much more slowly than the estimated 9 percent national average for 2005 but far from the crash that pessimists fear.

Steve Cochrane, managing director for the Economy.com consulting firm in Pennsylvania, said that while some overheated regions might experience 5 percent dips in housing prices in the near future, he does not foresee a general meltdown in either housing or the economy.

But the economy will not escape unscathed if housing cools, he said. Households could slow their spending if prices flatten or dip, and that will ripple into the retail sector. Construction, real estate and allied fields could quit growing and possibly lose jobs. And local governments, which have raked in revenue from transfer taxes on home sales, could see that money dry up, Cochrane said.

Recent studies have shown that when the Federal Reserve was lowering interest rates and mortgage rates were falling, homeowners took advantage of the twin factors of rising home prices and cheaper monthly payments to refinance their mortgages. They used the equity from their homes to pay down other debt, remodel or buy big-ticket items.

Many economists also say that rising home prices create a wealth effect that encourages spending among homeowners, but the phenomenon is difficult to quantify.

Now, as interest rates start creeping up and clouds hover over home prices, there are questions whether these sources of economic stimulation will turn in the opposite direction. To a large extent, such questions hinge on where home prices are headed.

An analysis of 299 metropolitan areas by National City Bank economist Richard DeKaser revealed a worrisome sign that prices are out of whack. DeKaser matched home price growth with household income growth in all 299 areas.

In a stable market, incomes and prices grow in step. However, DeKaser found that in 1 out of 5 metropolitan areas, prices had outpaced income and other fundamentals by at least 30 percent.

"These areas are at an especially high risk of future price corrections," he wrote in a recent report. Even so, DeKaser says the overall economy is resilient enough to take the hit. "The most likely scenario is that of an orderly correction, not a disruptive crash," he wrote.

But Dean Baker, a longtime housing bear with the Center for Economic and Policy Research in Washington, foresees a steeper, sharper, more catastrophic correction along the lines of the economic crash that hit Japan about a decade ago when its stock and housing markets crashed more or less together.

"I think housing prices on the average nationwide will fall 25 percent, and in some of the bubble markets, they could fall 30, 35, 40 percent," he said.

Berson, the Fannie Mae economist, echoed the concerns of those who feel that home prices have outstripped income growth to a worrisome degree. But the pattern is erratic. Some states in the middle of the country have seen little or no frothiness, while prices in the coastal markets have soared.

Two other factors worry Berson -- although he is hard-pressed to say how they will affect the macroeconomy.

The first is a rough doubling in the percentage of home and condominium purchases by investors as opposed to owner-occupants. The second is the growing percentage of loans taken out with variable rates and low or no down payments.

"What I can say is that trends that are unsustainable eventually stop," he said.